What is a Stock Split

Yogi Berra nailed it...

Cut my pizza into 4 slices — I’m not hungry enough to eat 8. Hold up, Yogi! It doesn’t matter how you cut it, the pizza is still the same size! This captures the same effect of a stock split: The number of underlying shares (or slices) changes, but the company itself is no different because of the split. Unlike a pizza though, over time, a company might grow or shrink, for instance, as it explores new business lines or faces production difficulties. These shifts could influence whether the company pursues another split, or considers a reverse split.

If companies that are doing well and have pricey shares pursue stock splits, then what do distressed companies do? Well, they can do the opposite. If a company is worried that its stock seems too cheap, it might consider a “reverse split” — That is, combining shares to raise its stock price. You might think of it like rolling together two smaller pieces of playdough into one larger ball. The amount of clay you have is exactly the same, but it’s now one bigger blob. Likewise, a company that goes through a reverse split has a smaller number of more expensive shares (but the underlying business is unchanged).

So, why do reverse splits happen? There are many possibilities. A company’s management team might think that their share price seems low compared to industry peers and competitors. They might even worry that a seemingly low-priced stock reflects poorly on their company’s potential. Another concern could be getting delisted from a stock exchange. Some exchanges, like the New York Stock Exchange, require a $1 per share minimum (and a company rarely wants to get kicked out of the club).

Regardless of whether you’re examining stock split, or a reverse stock split, here’s one thing to keep in mind: Ultimately, the market value of a publicly traded company is measured by its market capitalization, which is stock price multiplied by the number of shares outstanding.

Blue Apron, the meal-kit pioneer, is an example of a company that went through a reverse stock split. In June 2019, its shares fell below $1, trading at about $0.55 apiece. That was cheap. Too cheap, if you asked the Blue Apron Board of Directors. In fact, it was so cheap that the New York Stock Exchange, where those shares were listed, warned Blue Apron that if its stock price didn’t rise above $1 soon, it might be delisted. If that happened, then Blue Apron stock would have been relegated to the less accessible (and less prestigious) “over-the-counter” markets.

So, Blue Apron’s Board of Directors approved a 1-for-15 reverse stock split and publicly announced the news (Source: Blue Apron Investor Relations, June 13, 2019).

Bear in mind, if a company resorts to a reverse stock split to increase its share price, it’s often a concerning signal to investors. So, after a reverse stock split, it’s not uncommon for shares to trade lower because of persistent worries about the company’s future.

Here’s how the processes differ.

Stock split

• A company wants a lower stock price so its shares are more affordable to investors.
• So, the company splits its shares. To cut the share price in half, it would pursue a “2-for-1” or “2:1” stock split. Shares could split into even smaller pieces. To reduce the share price to one-eighth, for example, a company could pursue a “8-for-1” or “8:1” stock split.
• A 2-for-1 split doubles the number of shares. An 8-for-1 stock split multiples the number of shares by 8.
• The total value of the company doesn’t change — It’s the same pizza, which has been cut into smaller slices.

Reverse stock split

• A company wants a higher stock price so that it doesn’t get delisted from an exchange.
• So, the company combines shares in a reverse stock split. To double the stock price, it would pursue a “1-for-2” or “1:2” reverse stock split. To increase the stock price by a multiple of six it would do a “1-for-6” or “1:6” reverse stock split.
• A 1-for-2 reverse stock split halves the number of shares. A 6-for-1 reverse stock split reduces the overall number of shares by a factor of six.
• The total value of the company doesn’t change — It’s just a pizza that’s been cut up into fewer slices.

A public company’s board. Since stock splits and a reverse stock splits are corporate actions, they usually require the approval of the board of directors. Typically, the board is comprised of 8 to 12 individuals who have been elected to represent shareholder interests. Just as we saw with Blue Apron’s reverse stock split, the board is responsible for voting on whether a split should occur, factoring in whether it’s beneficial for shareholders. Once the vote is held and a date and ratio are chosen for the split, the company announces its plan.

There are plenty of ratios a board can choose from when they pursue a stock split. Some possible stock splits are 2-for-1, 3-for-1, and even 3-for-2. Reverse stock splits follow a similar pattern, except in reverse (i.e., 1-for-2, 1-for-3, or 2-for-3). You might also see them written with colons, like 2:1 or 1:2.

But there is one real-world difference to keep in mind. Since reverse stock splits often aim to raise a stock’s price , they often use larger numbers. For example, you may come across 1-for-7 reverse splits, or even 1-for-15 (as we saw with Blue Apron).

More dramatic splits and reverse splits also have the benefit of longevity. The bigger the split, the less likely it is that you’ll need to engage in another split sometime in the future.

This is the fascinating element about stock splits and reverse stock splits — They barely affect existing investors. This corporate action is more of a psychological game the company plays with potential future investors who might be concerned about the stock’s price. Because a stock split or reverse stock split changes the number of shares and the price of the shares in an inverse proportion, the overall value of the company stays the same.

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• Corporate Actions
• Stock Splits and Options
• Stock Splits and Fractional Shares